LONDON, Oct 13 (Reuters) – Consensus suggests the U.S. economy is on track to slow down. This explains why the S&P 500 Index (.SPX) has risen more than 20% over the past 12 months. The problem is that consensus often turns out to be wrong. In early 2007, most economists expected a mild slowdown from the U.S. housing slump. Going further back, investors were relatively upbeat after the stock market crash of October 1929, even as America teetered on the brink of recession. Maverick British economist Bernard Connolly argues that current expectations of a smooth descent are equally deluded.
Connolly is best known for his 1995 book „The Rotten Heart of Europe,” a scathing critique of the European Monetary Union that cost him his job at the European Commission. His latest book, „You Always Hurt What You Love: Central Banks and the Murder of Capitalism,” won him no friends in monetary policymaking circles. In Connolly’s view, central banks – mainly the US Federal Reserve – are responsible for a series of financial disasters over the past quarter century. Now, he says, they have taken us back to the brink.
Connolly’s beef is not with individual central bankers but with their economic models. He says it ignores the fact that economic and financial activities must be integrated over time. Central bank models assume that the economy never deviates from equilibrium and that economic shocks, when they do occur, are random, unpredictable, and self-correcting. American economist Michael Woodford’s “Interest and Prices”, published in 2003, is the central banker’s bible. However, Connolly says, “In the index to the 800 pages of Woodford’s book, there is not a single entry for 'risk’. 'Uncertainty’, 'Banks’ or 'Finance’.”
In the real world, things are different. Connolly is concerned with how economic activity takes shape over time: how current spending and saving link to future consumption and how current investment meets future demand. The economy is not always in equilibrium. Intertemporal convergence breaks down when real interest rates are beyond society’s time preferences, which is the ratio of value people place, on average, on future consumption. Problems also arise when interest rates are not aligned with corporate profits.
Accordingly, Western economies have been stuck in a state of imbalance for more than a quarter of a century. The rot occurred in the mid-1990s when America experienced an unexpected surge in productivity growth. According to Connolly, rising corporate profits should be accompanied by higher interest rates. Instead, Fed Chairman Alan Greenspan chose to keep US interest rates low, thereby helping to fuel the stock market bubble. American households, bolstered by their paper wealth, saved less and brought forward consumption from the future.
When the inevitable market crash occurred in 2000, the tough economy descended as demand dried up. The central bank responded by cutting the benchmark interest rate to 1% in 2003, thereby inflating another bubble, this time in residential housing. Again, households absorbed a portion of their bubble wealth by taking out hundreds of billions of dollars worth of home equity loans a year.
When the housing bust came in 2007, followed by the bankruptcy of Lehman Brothers a year later, central bankers turned a blind eye again. The world economy was poised to fall into an even deeper hole. The central bank responded by cutting interest rates to zero and using various tools to lower bond yields. Central bankers prevented another Great Depression and asset prices eventually rebounded.
In his market reports since the early 2000s, Connolly has consistently argued that Western economies are stuck in a state of transitional disequilibrium – real savings are increasingly bolstered by bubble wealth and consumer debt. These economic imbalances have prevented central banks from returning interest rates to normal levels. Whenever they try to do so, the economy threatens to collapse.
This insight helped Connolly anticipate both the Great Recession that began in 2008 and Europe’s sovereign debt crisis. Nothing fundamentally changed in his analysis. More and more bubble wealth is needed to sustain spending. It is impossible for central banks to normalize interest rates. After the U.S. economy hit the rocks in early 2019 and the stock market tumbled, the Fed abandoned an earlier attempt to raise rates. When Covid-19 arrived, short-term rates went back to zero.
Connolly describes real interest rates as being on a conveyor belt, heading deeper into negative territory. He predicts that long-term bond yields will eventually end up below short-term rates. Such an outcome would be disastrous for capitalism, as the problems of economic integration would become even more intractable. A financial system cannot function with a permanently inverted yield curve. Governments should participate in allocating debt. According to Connolly, the direction of travel is towards total socialism. That is, if liberalizing economic reforms are not enacted, they will increase productivity and allow interest rates to rise.
In this analysis, monetary conditions are no different than they were before Lehman failed. Central banks are primarily focused on controlling inflation, as they were before 2007. The central bank’s policy rate has returned to where it was in 2007. Connolly says the financial system cannot tolerate even this relatively „normal” rate. There is too much debt and bubble wealth. Although the yield curve has been inverted for some time, Connolly argues that the danger point occurs when long-term borrowing costs converge with short-term rates. This happened in mid-2007 again in recent weeks.
Another financial crisis isn’t far off in Connolly’s view. When markets fall, central bankers revert to their old ways, lowering interest rates and raising asset prices. In that scenario, long-term government bonds should offer better protection to investors. For example, U.S. Treasury inflation-protected bonds, whose face value rises in line with consumer prices, currently yield about 2.4% for a security maturing in 30 years. That’s a reasonable return in normal times and if Connolly’s analysis is even half right it could prove a sound investment.
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Edward Chancellor’s “The Price of Time: A True Story of Passion” was published in paperback in September.
Bernard Connolly’s book, „You Always Hurt What You Love: Central Banks and the Murder of Capitalism,” was published in hardback in September.
Editing by Peter Tal Larson, Streisand Neto and Thomas Shum
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